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Paying for College? Don't Start With Your 529s

Written by: Jeff Brown09/05/13 - 10:00 AM EDT

NEW YORK ( TheStreet) -- What's the best way to pay for college? (Assuming you're in the happy state of having some choices, that is.)

Most families with a child in college this fall have already paid for the current semester, often choosing from a variety of accounts: ordinary taxable investments with a brokerage or fund company, tax-free 529 plans , and plain old bank savings. Soon, they'll be preparing for the next semester's bills, then the ones after that.

So what's the best strategy for pulling money from these various sources?

For many, the first impulse is to start with the 529 accounts, but that's not necessarily best.

These state-sponsored plans are designed for college expenses, and contributions and investment gains are tax free if used for tuition and other approved expenses. Because the government imposes stiff penalties on withdrawals used for anything else, it is indeed best to empty your 529s before your child graduates.

But families should look closely at all their college accounts before tapping their 529s. College spending takes place over a relatively short period, four to six years, typically, so the key goal is to avoid having to pull money from an account full of volatile holdings such as stocks during a market downturn.

While 529s can contain stocks and often do, smart investors reduce the stock exposure gradually as the college years approach, favoring safety over returns . Target-date funds, a common 529 option, do this automatically. If your 529s are light on stocks, they are relatively safe holdings that will provide about the same amount of money anytime during the four college years regardless of how the markets behave.

That makes the 529 a great fallback to tap when other, more volatile holdings have taken a dip. If the 529 were large enough to pay for, say, two or three semesters, it could be held in reserve until the student's junior or senior year, and used earlier only if it was a bad time to tap other assets.

Bank savings and other cash holdings can be treated the same way, because they're not likely to lose value during the college years.

Many families, of course, also plan to tap taxable investments such as stocks or bonds, or mutual funds holding them.

Stocks are volatile. Because the main U.S. stock indexes have been rising smartly, it's tempting to continue holding stocks to benefit from any gains over the next few years. But it's pretty risky to keep money in stocks if you'll need it in the next year or two; downturns often last longer than that.